Thriving on Fed Rate Hike Far Off for Life Insurers

Life insurers are known to be one of the largest beneficiaries of rising interest rates, but they may not get much support, at least in the near term, from the modest increase in interest rates by the Fed in the last couple of years. Neither the magnitude nor the pace of rate hike has the potential to measurably increase life insurers' investment income that they need to meet policyholders' future claims.

That's because, for any gain, the rate-hike-driven improvement in income will have to more than offset the decline in yield on assets invested in. And the rate hikes so far are too small to fetch any significant benefit.

Concerns over the industry's growth despite rate hikes have made investors reluctant to bet on this industry. This is clearly evident from the Zacks classified Life Insurance Industry's 1.7% gain since the first rate hike in Dec 2015 versus 11.1% growth of the S&P 500.

However, the modest and slow rate hike is not totally inadequate, as yields on corporate and government bonds, which life insurers traditionally depend on for investing their accumulated premiums, are directly proportionate to the federal funds rate.

Further, high hedging costs, which have been marring profitability, are likely to decline with the rate hike. This will, in turn, alleviate the pressure on investment yields.

Looking back, life insurers have long been battered by the low interest rate environment. But they managed to stay afloat by going beyond their conservative approach and though capital flexibility. In order to keep their commitments to policyholders, they increasingly resorted to riskier asset classes - such as equities. The increased dependence on this strategy, however, has made them vulnerable to failure in paying claims, as there is no guarantee of steady returns from riskier assets.

What made life insurers resort to racier asset classes is ultra-low bond yields due to global growth concerns, in particular the Brexit storm. However, bond yields have strengthened since Donald Trump won the presidential race on the expectation of stronger economic growth and higher inflation based on an expansive fiscal policy. If this trend continues, life insurers will likely see better days.

Is the Industry Undervalued?

The industry's underperformance compared with the broader market has made its valuation too cheap.

Its price-to-book ratio, which is the best multiple for valuing life insurers because of their unpredictable financial results, is at 1.71 on a trailing 12 month basis. This level is much lower than the current P/B of 3.32 for the S&P 500 as well as the index's low of 2.87 over the last one year.

However, the ratio is at the high end of its range for the industry over that period, indicating limited upside.

The industry's trailing 12 month return on equity (ROE) also undercuts its growth potential. Its ROE of 6.97% compares unfavorably with 15.04% for the S&P 500, reflecting the fact that it is less efficient in using shareholder funds.

Business Alteration: Life Insurers' Saving Grace

Life insurers have not cowered under difficulties that the low-rate environment have created for them. Taking the ills in their stride, they have chosen to capitalize on the rapidly changing sector dynamics. As part of this effort, life insurers have reduced the sensitivity of their product lines to interest rates to some extent and have invested in less liquid assets. While this rationalization leads to lower benefit from a rising rate environment, it should make the growth path steady.

Along with altering economic and demographic conditions, more predictive risk-calculating techniques with the help of analytics are positioning life insurers for steady profitability.

Most importantly, after a sharp decline in the second half of 2015, life insurers managed to slightly recover net income in the last few quarters by trimming underwriting expenses and daring a modest increase in premiums. In fact, some life insurers are quietly hiking rates on some universal life policies in order to offset losses emanating from the tough backdrop. This action is actually narrowing the gap between what they receive as premium and what they promised to pay policyholders.

Life insurers have also been resorting to product modification and re-pricing, which should enhance their liability profiles and profitability. While re-pricing of traditional products with attractive additional features will help them earn more, product modification will lessen liabilities on the insurers' part by shifting risks related to equity and hedging to policyholders.

Moreover, a beefed-up capital market should strengthen the industry's liquidity profile in the upcoming quarters and help its participants confront any challenge that might crop up.

Economy and Market Lend Some Support

The resilience of the equity market should make variable annuity portfolios and other fee-driven businesses contribute a little more to the profits. Also, strengthening fundamentals of corporate bonds and improvement in the real estate market should keep credit-related investment losses below average.

Above all, an increase in disposable income on the back of a continued growth in the economy and declining unemployment should lead to a rise in demand for life insurance and annuity products.

How to Play Life Insurance Stocks

Life insurers' near-term prospects do not look promising at all and the valuation looks stretched as well. So, it would be prudent to stay away from life insurance stocks for now.

Here are a couple of bottom-ranked stocks that you should get rid of now:

American Equity Investment Life Holding Company (AEL):This Zacks Rank #5 (Strong Sell) stock lost about 3.4% over the last one year compared with the S&P 500's gain of 10.7%. The stock's earnings estimates for the current fiscal year were revised 18.9% downward over the last 60 days.

Aviva plc (AVVIY):A 3.9% downward revision in earnings estimates for the current fiscal year over the last 30 days precipitated a Zacks Rank #4 (Sell) for this stock. The price of this stock declined over 20.7% over the last one year.

However, investors, who can look beyond the near-term clouds to the industry's long-term prospects in a rising rate environment, may consider buying some stocks based on a favorable Zacks Rank.

We highly recommend the following top-ranked stocks:

Health Insurance Innovations, Inc. (HIIQ):This Zacks Rank #1 (Strong Buy) stock gained over 170% over the last one year. The stock's earnings estimates for the current year were revised 46.9% upward over the last 60 days.

Primerica, Inc. (PRI): This Zacks Rank #2 (Buy) stock gained over 49% over the last one year. Earnings estimates for the current fiscal year were revised 2.5% upward over the last 60 days.

Check out our latest U.S. Insurance Industry Outlook for more on the current state of affairs in the overall insurance market.

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PRIMERICA INC (PRI): Free Stock Analysis Report

HEALTH INS INN (HIIQ): Free Stock Analysis Report

AVIVA PLC-ADR (AVVIY): Free Stock Analysis Report

AMER EQUITY INV (AEL): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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